There are many types of ARMs, from monthly adjustable rates to loans that are fixed for up to the first 10 years. Most common are the 1 year ARM, 3/1 ARM and 5/1 ARM.. These loans are fixed for the initial term and adjustable for the remaining years. Adjustable rate mortgages normally have a 30 year amortization.
Monthly ARMs (1 Month Option ARM)
An adjustable rate mortgage loan with as many as four payment options: minimum payment, interest only, full principal and interest (30-year term) and full principal and interest (15-year term). These loans have an initial fixed interest rate for one to 60 months. After this period, the rate charged on the loan adjusts monthly, and payment option amounts adjust annually. Deferred interest, or negative amortization, is possible with these loans if you select that payment option. The choice of interest rate indexes is important with this type of loan. You will want a slow moving index like the 12-MTA (monthly treasury average) or the COFI (cost of funds index). For the lowest payments, choose the 40 year version.
1 year ARM Both the payment and the interest rate adjust once a year with a 2% annual rate cap. Like all ARMs, do not assume that the start rate, sometimes called a "teaser rate", will continue into the second year. These loans are almost always highly discounted in the first year. Even if rates in general are falling, you could see your rate increase in the second and third years. Usually offered with a total maximum increase of 6% above the initial start rate. May or may not be convertible to a fixed rate loan. These loans are usually indexed to the LIBOR (London Inter-bank Offered Rate) or the CMT (Constant Maturity Treasury securities). Both of these indexes are rather fast moving when there are changes in market conditions.
3/1, 5/1, 7/1 and 10/1 ARMs Depending on your needs and the rates offered, these loans may offer the security of a fixed rate loan with a lower rate than the conventional 30 year fixed rate mortgage. Ask about caps, there are first adjustment caps, annual caps and life of loan caps. After the initial fixed rate term of 3, 5, 7 or 10 years, the loans typically become ARMs.
Interest Only ARMs These loans normally offer a 30 year loan with the first 3, 5, 7 or 10 years as interest only. After the fixed rate ends, the loan becomes a normally amortizing adjustable rate mortgage for the remaining term. The main benefit is to have the lower payments for the first 5 years of the loan. The down side is that after the first 5 years you owe just as much you did when you originally took out the loan. Be sure to ask about caps and margins as with any ARM.
Balloon Mortgages The balloon/reset or extendable mortgage (sometimes referred to as a 5/25 or 7/23) has the first 5, 7 or 10 years at a given rate followed by an adjustment or demand for pay-off of the entire balance. Typically they adjust to either the FNMA (Fannie Mae) or FHLMC (Freddie Mac) wholesale index plus a margin. Read your disclosures and mortgage documents carefully! Often the lender inserts a clause stating that if you are late on any payments in the 12 months preceding the reset date or if the new adjusted rate is more than 5% over the start rate then the note will be called (you must pay off the entire balance). In the right circumstances, if you will only need the loan for 5 or 7 years, this is an excellent choice. If you are not sure you will be paying the loan off by the reset date, you would be better with a fixed rate or a standard adjustable rate mortgage with annual and lifetime caps.
